I am a senior editor at Forbes, covering legal affairs, corporate finance, macroeconomics and the occasional sailing story. I was the Southwest Bureau manager for Forbes in Houston from 1999 to 2003, when I returned home to Connecticut for a Knight fellowship at Yale Law School. Before that I worked for Bloomberg Business News in Houston and the late, great Dallas Times Herald and Houston Post. While I am a Chartered Financial Analyst and have a year of law school under my belt, most of what I know about financial journalism, I learned in Texas.

Merger Mania Fueled By Accounting Rules That Can Make A Bad Deal Look Good

A funny thing happened after Facebook announced on Feb. 19 that it was spending $19 billion to buy WhatsApp, an instant-messaging service with only 56 employees and $20 million in revenue: Its stock went up 6% over the next two weeks.

Traditionally investors have punished the stocks of big acquirers. Not this year. Shares in Verizon, Activis and Anheuser-Busch InBevAnheuser-Busch InBev have jumped or held firm after multibillion-dollar merger announcements.

The turnabout is noteworthy, since it comes as major companies, flush with cash and aiming to exploit their high stock prices and low borrowing costs, are ramping up acquisitions. In the first 11 weeks of 2014, $755 billion worth of mergers were announced, up from $578 billion in the full first quarter of 2013, according to BloombergBloomberg.

Rather than sit back and cheer the next big deal, however, investors would do better to dust off their green eyeshades. That’s because in addition to the operational risks of mergers (management distraction, turnover, poor fit) loosey-goosey acquisition accounting rules allow acquirers to make their purchases look like winners (at least for a time) even if they’re not.

“In all the areas of accounting this is the one that gives management teams the most discretion,” declares Matt Van Winkle, who spent two years at PricewaterhouseCoopersPricewaterhouseCoopers, became disillusioned with the info public auditors provide investors and went off to earn a Ph.D. at the University of Michigan, studying under accounting-manipulation guru Russell Lundholm.

Not that Van Winkle, 36, is complaining about the merger mush, since it provides fodder for him at his current gig as research director of Voyant Advisors, a San Diego firm that identifies overvalued companies for short-sellers.

Moreover, non-GAAP metrics (additional presentations in earnings reports) can lull investors into thinking each purchase is making the parent more valuable by, for example, stripping out integration costs–a major and real cost of growth through acquisition.

In 2012, when CGI Group, the Montreal-based company behind the ill-fated rollout of the ObamaCare federal insurance exchange, paid $2.2 billion for European competitor Logica, it identified $400 million in expected costs to integrate the two. CGI now estimates integration will cost $670 million, which it helpfully backed out of earnings so it could report a 51% increase in non-GAAP net income for its fiscal quarter ended Dec. 31, 2013.

Okay, a half-awake investor should be able to spot that non-GAAP fudge. The real story is the more obscure stuff done with GAAP accounting. As an example, Van Winkle points to Texas-based Chicago Bridge & Iron (CBI), which last year bought Shaw Group, a competitor in the engineering and construction business, for $2.2 billion, net of cash.

The multiyear contracts common in construction are paid over time, so companies book revenue using “percentage of completion” accounting; they add up a year’s expenditures, increase them by the expected profit margin and report the total as revenue for the period. This can lead to an earnings hit later if the job turns out to be less profitable than expected. Meanwhile, any money the company has received in advance of completing work is reported both as an asset (cash) and a liability (deferred revenue).

Here’s the play: When one company buys another, the new owner gets to reassess the profitability of the acquired firm’s ongoing contracts.

“You basically throw out the accounting of the acquired company and get to make up the entire thing based on guesswork,” Van Winkle says.

CBI apparently decided Shaw’s contracts were less profitable than previously reported, which had the effect of moving revenue and earnings that Shaw had already booked into CBI’s future. The clues that CBI used this ploy: Deferred revenue went up by $1.2 billion while goodwill from Shaw ballooned to $3.3 billion–more than CBI actually paid. Turns out, under GAAP merger accounting, CBI didn’t have to record the new lower profitability estimate as a charge against profits. Instead, it could treat it as an increase in goodwill–the excess of what it paid for Shaw over the value of assets acquired.

Make no mistake: This is all allowed by GAAP. But it could indicate trouble ahead. Some of the biggest changes CBI made were to Shaw’s nuclear contracts in Georgia and South Carolina, which have more than $800 million in disputed charges for cost overruns and change orders. CBI took a $745 million “margin fair value adjustment” after the Shaw purchase, mostly to reflect a lower estimated value for those contracts.

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Great article! Great example of how accounting manipulation can be made. I’d counter that GAAP would suggest there is an impairment to Goodwill that may neutralize the effects of deferring adjustments/revenue, but such impairment not always clearly observed/recognized timely enough.